The impending Basel III norms and margin requirements are driving up the demand for high-quality collateral.

1. The Collateral Conundrum:
A US$11 Trillion Opportunity?
New Basel III norms and margin requirements, along with growing
risk aversion, are driving up demand for high-quality collateral.
The market is appears ripe for innovative solutions that transform
and optimize this new currency in today’s financial market.
• Cognizant Reports
cognizant reports | June 2014

2. cognizant reports 2
The second paper presents a roadmap for
optimizing collateral, while the third examines
the crucial nature of margin requirements.
The Future of Financial Markets:
The Role of High-Quality Collateral
Executive Summary
As regulators shape the post-Lehman global
financial market, high-quality collateral has
emerged as the new reserve currency underpin-
ning global financial markets.
An environment of heightened risk aversion, plus
stringent regulations to restore trust and ensure
transparency, underline the need for high-quality
collateral. Further driving the demand are factors
such as centrally cleared, standardized derivative
contracts on exchanges, central banks’ need to bol-
ster their balance sheets and the new margining
standards for non-centrally cleared derivatives.
The cumulative demand for the forces shaping
the collateral field is pegged at US$11 trillion at
the higher end – even as the supply shrinks and
becomes unevenly distributed. This demand-
supply imbalance will make high-quality collateral
costly, and incentivize custodians and large
broker dealers to boost its supply.
In our view, the market is ripe for innovative solu-
tions for collateral transformation and optimiza-
tion. Firms can look to profit from prudent and
optimal use of high-quality collateral for regular
trading, and garner additional securities-lending
revenue by seeking higher economic rent for these
assets in an otherwise low-yield environment.
In this paper, the first in our three-part series
on collateral management, we examine the
dynamics that increase the need for collateral,
and suggest best practices for overseeing it.
One of the key drivers of the 2007-2009 financial
market crisis involved large, insufficiently collat-
eralized counterparty trade exposures. When a
few major counterparties failed to settle trades
on time, including those involving large exposures
not backed by high-quality collateral, the trust
deficit amplified – causing a systemic meltdown.
In the post-Lehman world, the industry is seeking
to bridge the trust deficit with trades backed by
high-quality collateral.
From unconventional monetary policies of central
banks to a raft of regulatory interventions such
as Basel III, Dodd Frank, European Market Infra-
structure Regulation, to the emerging collateral
highways championed by custodians, a series
of factors will fundamentally alter the demand-
supply scenario.
In the emerging rewired financial environment,
high-quality collateral will be the new currency
for safeguarding against counterparty risk, meet-
ing regulatory guidelines and buffering central
bank balance sheets.
Navigating the New Currency
High-quality collateral is a money-like asset
that doesn’t depreciate with risk – whether tied
to credit, duration or liquidity risk. In short, it is
Collateral Quality Grid
Figure 1
Note: The above grid highlights select collaterals to demonstrate how haircut rates range from 0 to 40%.
The exhaustive list includes numerous types of collateral, with tenor, risk, liquidity, etc., determining the haircut rate.
http://www.cmegroup.com/clearing/financial-and-collateral-management/#cash
Source: CME
0
10
20
30
40
Cash/USD
U.S.Treasury
Bills
TIPS
IEF2
U.S.Government
Agencies
Foreign
SoverignDebt
SelectMBS
Gold
IEF4
Stocks
LoC
IEF5
Haircut Rate %

3. cognizant reports 3
cash or any other fungible financial stock that can
be exchanged for cash credit immediately, with a
minimal haircut.
The Chicago Mercantile Exchange (CME), a lead-
ing derivatives trade exchange, has segmented
the acceptable quality collateral universe into
three broad categories: Cash is the top accepted
collateral with minimal haircut, followed by
the U.S. Treasury and
money market funds. (See
Figure 1, previous page).
Last year’s margin survey
by the International Swaps
and Derivatives Associa-
tion (ISDA) clearly identifies
the use of cash and govern-
ment securities as predomi-
nant collateral, constituting
91.1% of collateral received
and 97.1% of collateral delivered. In this equation,
cash accounts for 80% of the collateral used –
reflecting heightened risk aversion.
While cash and government securities play a key
role in collateralizing derivative trades, January
2014 statistics from the U.S. tri-party repo market
show a balanced collateral demand composition
where Treasury (US$571 billion), Agency securi-
ties (US$637 billion) and Equities (US$150 billion)
constitute 85% of the market, with cost implica-
tions for highly liquid treasuries in a stabilizing
market.1
Demand Drivers to Soak Up
US$11 Trillion
US$4.6 trillion and US$11.2 trillion under a
stressed market environment over the next five
years.2
(See Figure 2).
The key demand drivers are:
• Basel III: According to Bank for International
Settlements (BIS) estimates, the liquidity cov-
erage ratio provision under the new Basel III
norms is expected to result in a cumulative
collateral demand ranging from US$1.0 trillion
to US$2.5 trillion between 2013 and 2019.
• Derivative Clearing: According to ISDA and
CME, from 2013 in the U.S. and from 2014 in
Europe, the initial margining needs of high-
quality collateral for mandatory, exchange-
based clearing of standardized derivatives will
require between US$0.8 and US$2.0 trillion
under normal market conditions, and between
US$1.8 trillion and US$4.6 trillion under
stressed market conditions. In the new emerg-
ing (OTC) derivatives clearing environment,
variation margins will need to be posted in dif-
ferent currencies. This adds to the complexity
of the demand dimension.
• Margin Requirements: ISDA estimates the
initial margin and variation margin collateral
demand for non-centrally cleared derivatives to
be between US$0.8 trillion and US$1.2 trillion in
normal market conditions and between US$1.8
trillion and US$4.1 trillion in a stressed market.
Shrinking Collateral Supply
The International Monetary Fund (IMF) estimates
that between 2007 and 2011, the high-quality
collateral made available to the street (large
broker dealers) to meet the market demands by
commercial banks, hedge funds, money market
funds and securities lending operations fell from
US$10 trillion to US$6.2 trillion.
According to the Treasury Borrowing Advisory
Committee (TBAC), the estimated cumulative
incremental demand for high-quality collateral will
range between US$2.6 trillion and US$5.7 trillion
under normal market conditions, and between
High-quality
collateral is cash or
any other fungible
financial stock that
can be exchanged
for cash credit
immediately, with
a minimal haircut.
Regulatory Interventions Driving Demand Estimates
Drivers/USD tn 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
Margin
Requirements
Normal Market Stressed Market
Derivative
Clearing
Normal Market Stressed Market
Basel III
Source: TBAC
Figure 2

4. cognizant reports 4
According to the Treasury Borrowing Advisory
Committee (TBAC), there are other factors at play:
• AAA/AA assets: The primary issue of AAA/
AA assets is estimated to be US$2 trillion
annually, for at least the next five years.
• No rehypothecation: While the derivatives-
clearing and bilateral margining requirements
spike the demand for high-quality collateral,
the “no rehypothecation” rule crimps supply.
This negative impact on supply is estimated to
drain between US$1.2 trillion and US$2.4 trillion
under normal conditions, and US$3.2 trillion
and US$7.6 trillion under stressed conditions.
The Demand-Supply Mismatch and
Resulting Opportunities
(workflow, technology and staff) to optimize and
then transform collateral management practices
while creating the capabilities needed for a robust
regulatory reporting mechanism.
In our view, firms must establish a comprehensive
collateral management infrastructure to address:
• The demand side of collateral management
(portfolio margining).
• The collateral demand-supply gap, which can
be bridged by first optimizing the collateral
portfolio and then transforming the firm’s col-
lateral management practices. By optimizing,
we mean deploying advanced analytical tools
and smart collateral allocation practices that
help assure that the right collateral backs
the right trade, and developing the ability to
dynamically alter allocations to keep in step
with the changing dynamics over a trade’s
life cycle. After optimizing the collateral port-
folio, the collateral gap (if there is one) must
be resolved by strategies for portfolio trans-
formation in areas such as upgrading trades,
securities lending, margin financing and other
options designed to fully collateralize trade
exposures.
• The need for robust recordkeeping and regula-
tory reporting tools, which play an important
role in risk management.
• The need to implement communications
standards for managing complex collateral
processing and settlements. A robust reference
data system is critical to the margin calculation
process and a source for resolving disputes.
While demand for high-quality collateral can be
met comfortably in benign market conditions, the
situation becomes a material challenge when the
market is under duress. Also, in Europe, empirical
evidence shows that these assets are unevenly
distributed among core and peripheral countries.
This resulting imbalance has already created
interesting opportunities for collateral custodians
such as Euroclear and Clearstream in Europe,
and tri-party repo in the U.S., to build collateral
highways that address burgeoning demand and
seek rent for their collateral under custody.
Streamlining Collateral Management
Practices
This uneven demand-supply scenario will even-
tually spike the price of high-quality collateral.
Costly and in-demand collateral will incentivize
custodians and large broker dealers to boost
its supply and optimize its use. This will require
them to rewire their current internal operations
Footnotes
1
http://www.newyorkfed.org/banking/tpr_infr_reform_data.html.
2
http://www.treasury.gov/press-center/press-releases/Pages/jl1923.aspx.
3
”Rehypothecation” is an alternative name for ”re-pledging.” In other words, a party that receives
a pledge of collateral pledges the same collateral to a third party. In the derivatives market,
rehypothecation is sometimes called “re-use.”

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References
• “The future of repo: ’Too Much‘ or ’Too Little?‘” Speech by Andrew Hauser, Head of Sterling Markets
Division, Bank of England, and Chair of the Securities Lending and Repo Committee.
• Financial Stability Paper No. 18 – October, 2012 OTC derivatives reform and collateral demand impact.
• CGFS Papers No 49 Asset encumbrance, financial reform and the demand for collateral assets.
• SIFMA Collateral Regulatory Outlook Collateral Conference. Gregory J. Lyons, Emilie T. Hsu.
May 21, 2013.
• The Changing Collateral Space. Manmohan Singh WP/13/25, IMF working paper.
• ISDA Margin Survey 2013. June, 2013.
• Office of Debt Management, Fiscal Year 2013 Q2 Report, Treasury Borrowing Advisory Committee.
• http://www.newyorkfed.org/banking/pdf/jan14_tpr_stats.pdf.
Credits
Author
Anand Chandramouli, Director, Cognizant Research Center
Subject Matter Expert
Venkata Sista, Sr. Manager (Consulting) in Cognizant Business Consulting
Design
Harleen Bhatia, Design Team Lead
Chiranjeevi Manthri, Designer